By Ben Levisohn

Airline stocks like Delta Air Lines (DAL), American Airlines (AAL), United Continental (UAL) and Southwest Airlines (LUV) have surged this year but they’re looking anything but expensive.

AP

American Airlines, for instance, trades at just 10.5 times forward earnings, according to Morningstar, despite gaining 58% so far this year. United Continental, meanwhile, trades at just 8.9 times after gaining 16% in 2014. Delta Air Lines trades at 10.1 times after jumping 44%, while Southwest Airlines trades at 13.4 times after climbing 37% in so far in 2014.

Morgan Stanley’s John Godyn and team consider what it would take for investors to put a higher valuation for airline stocks:

We don’t disagree that cyclicals, like airlines, should see multiples contract as margins expand all else equal. But – we believe airline risk today is fundamentally mispriced, which argues for a parallel upward shift in their normal valuation ‘curve’ with respect to margins at all points. This is because tail risk in the group today is fundamentally different than in the past as a result of improved industry structure, the variabilization of cost structures due to higher fuel, and improved balance sheets. Simply put, if a global recession hit the industry tomorrow we don’t think any large
airline would be at legitimate risk of a liquidity squeeze (as a matter of history none of the legacies filed during the financial crisis). The notion that airline DCFs finally have terminal value justifies a higher multiple and in our view implies convergence to other industrial stocks. Therefore, we reiterate our view that airlines stand to benefit from multiple expansion as they increasingly compare more favorably vs. broader comp groups of industrials – one which we believe investors are increasingly willing to believe.

Godyn also thinks the market is underestimating United Continental. He explains why:

We reiterate our view that United Continental’s relative underperformance YTD is a buying opportunity. In fact, United Continental has only appreciated ~15% YTD vs. OW-rated legacy peers American Airlines and Delta Airlines which have moved up ~55% and ~43% YTD, respectively. Not surprisingly, our conversations with investors suggest that expectations are abnormally low of late – and we believe ripe for upward revision relative to peers. Today, across our coverage United Continental has the most upside through YE14 and the most upside to 2015 consensus EPS based on our estimates.

Last week Delta attempted a $10 broad-based fare hike. The majority of the airlines
matched the fare increase, however Southwest remained on the sidelines. Southwest
is the one airline that needs to match for fare increases to stick. Year-to-date the airlines have attempted 13 fare increases, with four successful and one pending, focusing mostly on the business traveler and to/from Canada to offset currency weakness. As we indicated above, the demand environment is strong which should enable higher prices.

Shares of American Airlines have gained 1.8% to $39.81 at 11:12 a.m., while United Continental has ricked up 0.3% to $43.71, Delta Air Lines has risen 1.1% to $39.58 and Southwest Airlines has advanced 0.4% to $25.90.

About Stocks To Watch

Earnings reports, corporate strategies and analyst insights are all part of what moves stocks, and they’re all covered by the Stocks to Watch blog. We also look at macro issues, investor sentiments and hidden trends that are affecting the market. Stocks to Watch gives you the full picture of the U.S. stock markets, all day long.

The blog is written by Ben Levisohn, a former stock trader who has covered financial markets for the Wall Street Journal, Bloomberg and BusinessWeek.